Regulation and the Marginalist Revolution

Abstract

The marginalist revolution in economics became the foundation for the modern regulatory State with its “mixed” economy. Marginalism completely overturned economists’ theory of value. It developed in the late nineteenth century in England, the Continent and the United States. For the classical political economists, value was a function of past averages. One good example is the wage-fund theory, which saw the optimal rate of wages as a function of the firm’s ability to save from previous profits. Another is the classical theory of corporate finance, which assessed a corporation’s worth by looking at how much capital had been paid in. Marginalism substituted forwarded looking theories based on expectations about firm and market performance. The optimal rate of wages became the laborer’s expected contribution to the value of the employer; and the value of the corporation became the firm’s anticipated profits. Marginalism swept through university economics in the United States, and by 1920 or so virtually every academic economist was a marginalist. This paper considers the historical influence of marginalism on the development of regulatory policy in the United States. Marginalism’s critique of the laissez faire state cut very broadly, undermining much of classical political economy. My view is at odds with those who argue that marginalism saved capitalism by rationalizing it as a more defensible buttress against incipient socialism. While marginalism did permit economists and policy makers to strike a middle ground between laissez faire and socialism, the “middle ground” was in fact very far removed from the antistatist vision of the classical political economists. Ironically, regulation plus private ownership was able to go much further in the United States than socialism ever could because it preserved the rhetoric of capital as privately owned – but all the while depriving private firms of many of the most important indicia of ownership. As a theory of value, marginalism was much more realistic than classical political economy about how market actors behave. At the same time, however, valuations based on expectations about the future, which necessarily included risk, required both more technical analysis, the accommodation of more uncertainty, and tradeoffs among different interest groups. These changes had a powerful effect on the development of modern regulatory policy in the United States. Marginalism upended many of the classical conceptions about the market, including assumptions about their robustness, as well as the need for government intervention and the optimal type. For regulatory policy the most important issues were: (1) The fixed-cost controversy and the scope of natural monopoly; (2) cost classification, incentives, and ratemaking; (3) the changing domain of market failure, and regulation and Pigouvian taxes as correctives (4) market diversity and the rise of sector regulation; (5) deregulation; (6) concerns about the distribution of wealth; (7) the development of cost-benefit analysis; and (8) the assessment of risk. The final section examines risk management under marginalism by looking at two diverse but important areas: negligence and products liability in tort law, and administrative review of patents by the Patent Trial and Appeal Board.